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Hedge Funds as Pension Investments

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Is There Really an Alternative Universe?

Is there a parallel universe where things fall upwards, time goes backwards, and none of the other rules apply? I don’t know. But, parts of Wall Street would like you to think so.

The ever so seductive argument of the hedge fund hucksters is that they live in a universe of “total return”. Total return investors generate liberal consistent positive returns. By implication, these returns are far above the Treasury bill rates which normally define risk free returns. Yet, they should never expect to have a loss! How extraordinary!

Hedge fund operators are undeterred by the overwhelming evidence that high returns cannot be generated without risk. Somehow they manage to convince otherwise sober and sensible people that they are exempt from normal financial economic law. Houdini would have been proud!

The rest of us mere mortals inhabit a universe of “relative return”, an undesirable place, populated by a race of distinctly lower intelligence and breeding. Pity the poor relative return investor who subjects himself to occasional losses as the price of obtaining above the zero risk rate returns. These inferior beings are such backward brutes that they deserve to have fluctuating returns.

To inhabit this Never-Never Land of total return, you must only suspend disbelief, worship at the altar of the inefficient market, and put your common sense out to pasture.

  • Convince yourself that there is a massively inefficient market which can be consistently exploited by hedge fund managers to achieve superior risk adjusted returns. These superb managers will somehow float magically above the capital market line which restricts the rest of us. In other words, there is a free lunch out there for the taking. Even more absurd is the idea that those nice boys from Wall Street are going to share it with you.
  • Next, believe that these managers are so good that they can overcome exorbitant fees and transaction costs. Fees hover around 2% of assets under management plus 20% of profits!
  • Finally, accept that securities regulation, registration, disclosure, and transparency are very bad things indeed. Superior managers ought not to be encumbered by everyday investor protections. Even an advanced being might lose his mojo in such inhibiting circumstances. You don’t need to know where your money is being invested, what the strategy is, or how you are being protected against fraud, conflicts of interest or excessive charges.

Pension funds are apparently buying into this nonsense big time. The New York Times (November 27, 2005) reported that pensions expect to invest up to $300 billion in hedge funds in 2008, up from only $5 billion ten years ago. What can they be thinking of?

It’s bad enough when individuals make critical mistakes with their own funds, but the Employment Retirement Security Act (ERISA) holds pension fiduciaries to much higher standards. It’s hard to square the fiduciary’s absolute requirement to act prudently with hedge fund strategies built out of thin hot air.

During the bear market of 2000 to 2002 many poorly managed pension funds got burned badly by inept investment strategy. They don’t want that to happen again! Hedge funds give those same bungling managers the opportunity to jump smoothly from the frying pan into the fire. The opportunity to follow up one disaster with another seems irresistible. There is no way that they can understand the risks, costs, or probable future performance of a hedge fund portfolio. Yet, as fiduciaries they have an absolute obligation to do so.

A few companies are taking huge positions in hedge funds. Weyerhaeuser has 39% of its pension invested in them according to that same New York Times article. As a side benefit for taking absurd positions in risky assets that they can’t possibly understand, monitor or model, the company increased their portfolio assumed return projection to 9.5%! I believe that assumption falls far outside the range of reasonableness for a pension account, and it’s certainly way above . This outlandish return projection allows the company to slash annual funding costs. And, of course, if it doesn’t work out, the guarantor of last resort is the US taxpayer through the already insolvent PBGC.

For fiduciaries to take risks of this magnitude simply boggles the mind. Pension actuaries, the SEC, Labor Department, Congress and PBGC are all charged with protecting the nation’s pensions. For them to put up with it defies description. This is just plain nuts! Or, perhaps there really is an alternative universe after all!